The Perils of Public Enforcement of Shareholders’ Duties

As part of a research project on ‘Shareholders’ Duties’, such as inter alia the duties to disclose (e.g. major holdings, engagement policy etc.), and the duty not to abuse rights, this post aims to question the adaptability and efficiency of public enforcement mechanisms in the area of shareholders’ governance and engagement duties. It emphasizes the importance of social enforcement by critically challenging the orientation of the revised Shareholder Rights Directive 2017/828/EU (SRD), which imposes more stringent legal norms and enforcement tools upon shareholders. Our recommendations are therefore relevant to the forthcoming transposition of the SRD with regard to enforcement mechanisms.

The Enforcement of Shareholder Duties

Private enforcement remains, to a great extent, the most appropriate spectrum of action for dealing with violations of shareholder duties within the scope of company law. Nevertheless, as capital market law violations have gradually gained importance, due to their frequency and impact upon a large spectrum of market actors, public enforcement has taken on a more prominent role in the defence of public interests (such as market integrity) that go beyond the purely private (company’s and shareholder’s) interests potentially affected by a breach of shareholder duties.

As far as the traditional shareholders’ duties are concerned (e.g. notification of major holdings), national authorities have already shown an increased degree of familiarity and sophistication that could convey positive signs as to the efficiency of legal enforcement. Nevertheless, concerns may be raised with regard to the suitability of public enforcement in the area of the emerging shareholders’ governance and engagement duties (i.e duties to disclose the engagement policy developed by institutional investors and asset owners, as well as the extent to which investment strategies are in line with the profile and duration of their liabilities and how they contribute to the medium- to long-term performance of their assets). Article 14b of the SRD, which lays out the possibility of imposing administrative sanctions and measures for the breach of, inter alia, the above mentioned governance and engagement duties, may create more harm than good, as explained below. Social enforcement (namely the reaction stemming from market actors with regard to the infringement of applicable rules) should therefore be preferred in this area.

The Risks of Public Enforcement of Stewardship

There are four main concerns about public enforcement (i.e. administrative sanctions or measures imposed by national authorities, such as pecuniary sanctions or disenfranchisement of voting rights, in the presence of a violation) of the new stewardship (governance/engagement) shareholder’s duties.

First, we argue that public enforcement risks creating an operational environment that is overly regulated and dissuading shareholders from conducting their activities in capital markets with flexibility. Creating unreasonably burdensome conditions for market actors may also impede the development of innovative engagement solutions, since shareholders will be primarily concerned by the necessity to comply with a series of legal requirements and not by the effectiveness of their strategies.

Secondly, public enforcement does not fit harmoniously with the conceptual premise of engagement duties whose main benefit is to trigger further engagement in the market, increase the educational benefits of disclosure in this area, and gradually fight against shareholder apathy. This is because concerned parties will inevitably focus on the liability factor of compliance, and might be deterred from disclosing further information. Public enforcement may therefore transform educational tools into liability risks and severely undermine the SRD objectives.

Thirdly, in the presence of public enforcement, the recipients of disclosure will rely mechanistically upon national authorities instead of engaging with shareholders. Indeed, they will probably perceive administrative measures and sanctions as an adequate safeguard from non-compliance risks; hence, they might not be as motivated to interact with shareholders to challenge their strategies, or seek to obtain more information relevant to their priorities.

Lastly, public enforcement will risk legitimizing certain borderline shareholder practices in the absence of actions taken by national authorities. Indeed, if such authorities fail to investigate non-compliance elements and, subsequently, to sanction them, the engagement duties will be perceived by the market as complied with and not raising any further concerns. An inactive regulatory stance can therefore be seen as an ex post certification of dubious practices. The concerned shareholders will also be enabled to stop engaging with other parties that may want to challenge their activities and further engage in dialogue with them. The overall risk will therefore be a mutually neutralising effect of engagement and further apathy, from the perspectives of both the concerned shareholders and the recipients of information.

To avoid the abovementioned risk and counter-productive effects of the EU shareholder engagement agenda, administrative measures and sanctions could, where appropriate, be exclusively envisaged for the simple and straightforward lack of disclosure (namely statements without any associated explanation, as required in such cases according to the ‘comply or explain’ principle) of either the institutional investor engagement policy or the annual disclosure related to the implementation of such policy, or the arrangements with asset managers. National authorities should be able to simply verify if such disclosure (or the explanation required) has been published, and should be in a position to impose sanctions or other measures if this is not the case. The examination of statements should be based on the compliance with a disclosure obligation (or the publication of an explanation where applicable) and any interpretation of their content by national authorities for enforcement purposes should not be permissible. This stance is justified in light of the lack of clarity of the engagement and governance duties themselves, the difficulty in deciphering the expected outcome of such duties, and the embryonic stage of their understanding by national authorities. Indeed, authorities will face serious obstacles in defining engagement and assessing its quality on each and every case (given their inevitable differences and distinctive features), in deciding whether the duty to disclose has been effectively complied with, in clarifying borderline cases where engagement evolves into different directions or inevitably changes during or after the disclosure period (triggering automatically non-compliance suspicions) and in analyzing the quality of explanations provided in case of deviation.  

Conclusion

As a consequence, for the time being, social enforcement mechanisms should be maintained, while resources and time should be invested to increase the familiarity of national authorities with shareholders’ duties, so as to gradually prepare them for the implementation of enforcement tools in the future. Enforcement tools will only achieve desirable levels of efficiency when used meticulously and wisely by the legal order.

Konstantinos Sergakis is Senior Lecturer in Law at the University of Glasgow.